Breakingviews - Oil market inferno claims victims of all sizes

LONDON (Reuters Breakingviews) - This week’s inferno in the oil market looks like a depressingly familiar story. Scores of dumb retail investors hoping for a bounce in the price of crude were immolated while savvy institutional players supplied petrol and matches. The reality is less straightforward.

It’s true that plenty of unsophisticated investors watched their money go up in smoke when the price of U.S. crude for delivery in May fell to minus $37 per barrel on Monday. Normally, speculators offload their contracts to buyers willing and able to take physical delivery of the oil in Cushing, Oklahoma. But with storage space at a premium, financial investors ended up in the unprecedented position of having to pay others to hold the black stuff.

One Chinese student lost nearly $10,000 investing in a Bank of China, futures product linked to the West Texas Intermediate May contract, part of a group of customers that collectively lost $85 million. Interactive Brokers said on Tuesday it was setting aside $88 million for losses after some of its clients had to close their positions. Most notably, the U.S. Securities and Exchange Commission stepped in to restrict the growth of United States Oil, a $4 billion exchange-traded product whose already battered share price fell 11% on Monday. In the previous week, investors hoping to profit from a post-coronavirus oil price rebound had pumped $1.6 billion to the product.

The conflagration has exposed the flawed way in which financial vehicles like USO have invested in the oil market. Covid-19 has caused demand to collapse, leading to a supply glut. This has pushed the price of oil for near-term delivery below the price for later dates. As USO largely held one-month oil futures contracts which it sold when they were close to expiry in order to buy contracts due the following month, that meant it would consistently lose money. To make matters worse, falling oil prices tend to suck in investors betting on a rebound.

Yet it’s far from certain that retail punters were alone in sparking Monday’s firestorm. What enabled it, according to a person familiar with the situation, was a shrewd set of market moves by big oil trading houses. Having worked out that the supply glut was going to overwhelm storage capacity, they snapped up remaining space in Cushing. On Monday, the day before the WTI May contract expired, those traders were able to name their price. In the end, some were paid $37 per barrel to take delivery of oil. Given that WTI contracts for delivery in, say, December 2020 were trading at nearly $30 a barrel earlier this week, the traders made a tidy profit.

Who were these unfortunate sellers, though? Some investors lost money on Bank of China products called “bao” – which ironically means “treasure” in Chinese – because they were still holding them on Monday. USO, however, may have escaped with less severe burns. It does own 25% of the WTI June contract, a person familiar with the situation told Breakingviews, and that dived in price this week before partially recovering. But USO’s chief executive said it had already sold out of the May contract before Monday.

An alternative theory, provided by Energy Intelligence, is that the forced sellers of the May contract price were hedge funds, including two as-yet unnamed institutions.

The true victims of this week’s oil blaze may never be all properly identified. Yet the easy assumption that smart institutional investors are taking advantage of dumb retail money was already suspect. Singapore-based Hin Leong Trading, run by veteran market player O.K. Lim, this week admitted to losing $800 million on oil futures. According to Bloomberg, it had bet on a quicker post-virus recovery.

Commodities trading is risky even for big trading houses with knowledge of physical oil flows, access to storage and billions of dollars in bank credit lines. The shuttering of USO and the BoC product to new money implies regulators have belatedly woken up to the risks of offering retail investors access to markets that were previously off limits. Even so, this week’s events suggest that even supposedly smart money managers can suffer first-degree burns.

Breakingviews

Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.